LOUISE FAIRSAVE: Present value of cash
THE TIME VALUE OF MONEY means that the money in hand today is worth more than the same amount of money provided at a future date. A simpler, old-fashioned way of saying this is: “a bird in the hand is worth more than two in the bush”. When it comes to their money, people definitely prefer the bird in the hand. There is greater difficulty understanding the two birds in the bush.
For example, suppose Sarah’s granny died today and left her $20 000 towards her education. However, the money was to be held in trust for the next ten years until Sarah turns 18 and is at the stage of entering a university. If someone had offered Sarah $9 265 for that inheritance today, it would likely be considered highway robbery to many people. However, that is the value of Sarah’s inheritance today if it is discounted at an eight per cent rate over the next ten years.
Let us say that again, in a different way: the value of a $20 000 amount paid ten years from now is worth $9 265 today if discounted at eight per cent. So, to have the bird in the hand today – the $9 265 would be equivalent to $20 000 in ten years if you can earn eight per cent annual interest. Somehow, it is easier to understand how $9 265 invested today can become $20 000 in ten years if invested at eight per cent.
It is useful to be able to assess the present value and/or the future value of any sum discounted or invested for a number of years “n” for an interest rate “r”. This can be easily calculated using present and future value tables which can be found on the Internet. In order to access these tables, you can google:
“Present value table pdf”
“Future value table pdf”
In the present value table, there are different numbers per row per column. The number in row “n” and column “r” provides the number that the sum should be multiplied by to get what the amount received “n” years ahead will be worth today if discounted at “r” interest rate. So, $35 000 received 12 years from now and discounted at four per cent is worth $21 875 today ($35 000 x 0.625). The 0.625 is the number drawn from the 12th row of the fourth column of the present value table.
You can repeat this process for any amount, for any number of years at any of the interest rates presented in the table.
Similarly, the future value of $21 875 invested for 12 years at four per cent can be computed using the number from the 12th row of the fourth column of the future value table (1.601). That works out to $35 022 ($21 875 x 1.601). The slight difference arises from rounding.
The shorter the period and the lower the discount rate, the more the bird in the hand would be worth and vice versa. Similarly, the longer the period the sum is invested and the higher the interest rate, the more the two birds in the bush will be worth.
These examples are presented to emphasise further the importance of considering the alternative to spending in our New Year thrust to spend more wisely. The alternatives to spending is saving and investing. It is in our interest to save and invest part of our earnings. Being able to understand how and what drivers will make our money grow is fundamental to making our decisions about spending.
The next article will look at evaluating the value of regular investing and also the cost of buying a stream of income, like retirement funding.
• Louise Fairsave is a personal financial management adviser, providing practical advice on money and estate matters. Her advice is general in nature; readers should seek advice about their specific circumstances. This column is sponsored by the Barbados Workers’ Union Co-op Credit Union Ltd.